Multifamily assets, whether owned as actual properties or in a real estate investment trust, of REIT, offer the opportunity to benefit in two different ways. Like other real estate investments, they have historically increased in value year after year. In addition, they offer cash flow that comes from what is left after the tenants' rents are used to pay off the building's mortgage and operating expenses.
The Capitalization Rate
One of the most common investment metrics for multifamily properties is the capitalization, or cap, rate. To calculate it, you divide a property's price into its net operating income -- the money that is left from rent payments after the building's recurring expenses have been paid, excluding its loan payments. For instance, a $2 million property with a $155,000 net operating income would have a cap rate of 0.0775 or 7.75 percent. This represents the return before debt.
The cash-on-cash return divides the down payment into the net cash flow after debt service. For instance, an investor might buy the property with $500,000 down and a $1,500,000 loan. If the loan had a 30-year amortization and a 5.25 percent interest rate, its annual payments would add up to $99,397, leaving $55,603 of cash flow. Dividing that $55,603 of cash flow into the $500,000 down payment gives a cash-on-cash return of 11.1 percent.
Cap Rate Norms
Cap rates vary based on the type of property and its location, as well as on the general sentiment of the market. According to Marcus and Millichap's National Apartment Report, the average cap rate for multifamily properties was more than 8 percent in 2002, while it was just barely 6 percent in 2012. Cassidy Turley, another commercial real estate brokerage, showed in its 2013 U.S. Multifamily Forecast Report a range of anywhere from 4 to 9 percent cap rates, depending on the type of property. Cassidy Turley showed the highest-quality Class A product carrying cap rates of 4 to 6 percent in major markets like San Francisco or New York, while a "value-add" Class C product in a third-tier marketplace carried a cap rate of at least 9 percent.
When investors borrow money to purchase investment real estate, one feature they look for is "positive leverage." Positive leverage refers to when the return on the investment is higher than the cost of the loan, and it can be a tool to check for a potentially worthwhile investment. Banks also test a property's return relative to the cost of the loan by applying a debt service coverage ratio. To calculate the ratio, banks divide a property's annual debt service into its net operating income. A property with a $150,000 net operating income and $99,397 in debt service would have a 1.51 ratio. Typically, lenders like to see a ratio of at least 1.2; the higher the ratio, the higher the return relative to the cost of the loan.
Multifamily REITs let investors participate in the real estate markets without having to actually find and own properties. Many REITs own extremely high-quality assets that are priced in the tens of millions or hundreds of millions of dollars and are out of reach of all but the richest investors. One of the costs of owing a REIT is that the returns are relatively low. In a survey covered in MarketWatch in May 2013, many of the nation's largest REITs focusing on multifamily properties paid dividend yields of between 2.9 and 3.9 percent of the share price.
Steve Lander has been a writer since 1996, with experience in the fields of financial services, real estate and technology. His work has appeared in trade publications such as the "Minnesota Real Estate Journal" and "Minnesota Multi-Housing Association Advocate." Lander holds a Bachelor of Arts in political science from Columbia University.